The Value of a Low Valuation



You can value investor preferred shares at a significant markup to your common stock by giving a non-participating liquidation preference. So you can raise $50m at $800m and not completely wreck the next round of options. It’s called the Thin Common strategy. The idea is you sell X shares for $50mm, but since they also got a $50mm preference as part of the deal, the common share value is still no-where near $50mm / X.

What Evan Spiegel is saying, which is spot-on, is that having revenue will encourage a Section 409a valuation based on discounted cash-flow for common stock, which will be minuscule compared to the investor value on preferred shares. 409a is about gaining a safe-harbor where your valuation is presumed reasonable and harder for the IRS to contest.

This allows them to keep moving shares into employees hands at a reasonable rate, or if options, then issuing them without an impossibly high strike price. The problem Mitch Lasky is pointing out is the Facebook offer also plays into the 409a to some extent. If someone offers you $3 billion cash, it’s hard to claim you are worth less than $3 billion.

If you are issuing restricted stock, or RSUs, you have to price them at fair market value, and either the employee pays you that money, or the value of the shares is taxable income as they vest. If your valuation is too high, any modest stock grant (remember, they are only 30 employees and pre-revenue at this point) requires someone to pay ~40% of that amount in cash as taxes. So it becomes quickly impossible to give a meaningful number of shares — the tax consequence and drain on cash is just too immense.

For example, lets say they issue 1% of their shares to their 30 employees next year. They get a 409a valuation based on $0 revenue, 13 months of runway, and a plan to hopefully possibly achieve $20mm of revenue in the next 12 months. Their accountant says somehow that equals a $200mm common stock value, so they owe taxes on $2mm of income. Not so bad. But if the IRS comes back and says, wait just a minute, we say those shares were actually worth $3 billion at the time, so you owe us taxes on $30mm of regular income, and another $30mm in penalties…. Just the tax bill would be more money than Snapchat has in the bank.

Anyone who started at Snapchat early on would have received shares at par value (e.g. $0.001/share), and if they were restricted, would have done an 83(b) election to pay tax up-front at the current value, instead of paying tax at the increasing market value as they vested over time.

If anyone at Snapchat has significant vesting shares and did not do the 83(b) election to pay tax at an early-days valuation, they are now in an impossible situation, because every month they vest more shares, they owe millions of dollars to the IRS and they have no liquidity with which to pay the tax man.

The system is stupidly broken. The way I think it should work is that freshly minted common stock should transfer tax-free until a subsequent transfer or sale (not including transfers through probate). Then the full value should be taxed at short or long-term capital gain. There’s absolutely no reason to tax as income, or even attempt to value, the initial issuance of unregistered and non-transferable securities of a private company. Simply wait till they are first sold, or otherwise encumbered, and collect capital gains taxes from the market value at that time. Registered stock could remain under the current rules.

In a sense, even declining an offer from Facebook cuts off new hires from obtaining reasonably priced shares, thwarting Snapchat’s ability to hire and retain the best talent. It’s an interesting “damned if you don’t” scenario.